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Painful memories are discouraging many investors from putting money into the financial sector. At Coutts we believe that subordinated bank debt can offer attractive yields especially in the current low to rising interest rate environment.

Following the 2008 financial crisis, central banks acted quickly to restore confidence and stability in economies by cutting interest rates to record low levels and implementing quantitative easing programmes. At the same time, Europe’s financial regulators began to develop new standards to ensure banks could withstand another crisis without relying on government bailouts.

In today’s low-rate environment, subordinated debt offers an attractive yield, less sensitivity to changes in interest rates than other bonds and less volatile returns than equities.

Historically, banks had been required to hold sufficient capital to absorb unexpected losses that might arise from another shock or combination of events – such as a severe global recession, a sharp fall in house prices or negative interest rates as well as fines and other costs associated with misconduct. Today’s tighter regulatory framework means that banks must hold even more capital to act as a buffer against substantial future losses.

In response, Europe’s banks have issued more subordinated debt – about €214bn since regulations started taking effect – as a way of generating this extra capital. Like most fixed income securities, these bonds pay a regular coupon,  but there are strings attached. That’s because the regulators have focused on shifting the financial burden of any potential problems away from taxpayers and onto investors.

As the name suggests, subordinated debt is repayable after other debts have been paid, which does make it more risky. In particular , if a bank comes under stress and its core capital falls below a certain threshold then holders of the subordinated bonds can find their stake converted to equity or even written down to zero. The regulators also have the discretion to halt the coupon payments in certain circumstances.

 

Algebris Financial Credit Fund

 

1 Intesa Sanpaolo 
8%
2 UBS 8%
3 BBVA 7%
4 Lloyds 7%
5 Unicredit 5%
6 Société Générale 
5%
7 Barclays
5%
8 Crédit Agricole 
5%
9 BNP Paribas 
4%
10 Credit Suisse 
4%

Too old to rock and roll, TOO BIG TO FAIL?

We believe current valuations are attractive because the market is overestimating the default risk. Despite concerns, no bank has missed a coupon payment on its subordinated debt. In today’s low-rate environment, this asset class offers an attractive yield, less sensitivity to changes in interest rates than other bonds and less volatile returns than equities.

In our view, the higher income from subordinated bank debt more than compensates for the additional credit risk due to the ranking behind senior bonds. Since the financial crisis, Europe’s banks have raised substantial amounts of capital and they are lending more conservatively. While many of the risks associated with the sector have receded, the asset class remains overlooked.

Regardless of underlying conditions, banks will continue to issue regulatory capital in the form of subordinated debt to meet their requirements, creating an ongoing opportunity.

The banks that issue these bonds are seen by regulators as “systematically important institutions” whose failure might trigger a financial crisis. More colloquially, they are seen as “too big to fail”, and are subject to regular stress tests by their regulators – the Bank of England in the UK and the European Banking Authority in the eurozone.

These tests are based on hypothetical scenarios. Last year’s results were mostly encouraging, showing that most banks have enough capital to withstand another shock of the scale seen in 2008.

Yet risks remain, with concerns over the amount of bad loans still plaguing European banks. The Bank of England has highlighted risks in the UK which include the uncertainty created by the Brexit vote, consequent risks to the commercial property sector, high levels of debt in UK households and the potential vulnerability of the economy to a reduction in foreign investors buying UK debt.

 

Getting specialist help

Not all subordinated bonds are created equal. They have different characteristics associated with their order on the capital structure as well as what happens if the issuing bank comes under stress. This complexity as well as minimum investment requirements mean they are only available to institutional investors.

We have included exposure to subordinated bank debt in many of our portfolios through two funds with the specialist experience and resources required to invest in this asset class. One is managed by Pimco, one of the world’s largest and most experienced fixed income investors. The other is managed by Algebris, a boutique investment manager specialising in the financial sector.

These actively managed funds invest primarily in subordinated debt instruments issued by banks, insurance companies and other specialty finance companies. Most investments are concentrated in core and higher-quality debt –  tier 1, tier 2, and contingent convertible (CoCo) bonds – although the funds maintain the flexibility to invest across the capital structure.

 

Looking forwards

Europe’s financial sector remains vulnerable to high consumer debt levels and potential market volatility from political uncertainty related to President Trump, Brexit and upcoming European elections. Recent earnings announcements within the sector have been mixed, though a number of UK banks have reported strong results as they improve their balance sheets and the outlook for the year is looking more optimistic.

Regardless of underlying conditions, banks must continue to issue regulatory capital in the form of subordinated debt to meet their requirements, creating an ongoing opportunity. We believe this asset class can offer exposure to higher-yielding capital securities, which can provide attractive returns relative to bank equities or traditional high-yield bonds.

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